It would be comic if the consequences weren't so grim. There is no economic failure, it turns out, which cannot be hailed by George Osborne as a vindication of the policies that brought it about. Faced with the decision by the credit agency Moody's to scrap Britain's AAA rating, the chancellor declared it was yet another reason to stick to austerity – and the "clearest possible warning" to anyone who might think of breaking with it.

But for Osborne and the coalition, safeguarding Britain's credit rating has been a central justification for the most swingeing programme of cuts and tax increases for 90 years. Along with slashing the deficit, cutting borrowing and bringing down debt within five years, it was a central test of market confidence that Osborne and the coalition set for themselves.

And they have failed on every single one. The structural deficit and debt targets have had to be abandoned, as austerity plans have been extended to 2018. Borrowing is now forecast to be £212bn higher than planned over this parliament. Moody's downgrade report gives a clue as to why that might be: "sluggish growth" is now expected to "extend into the second half of the decade" with a consequent "high and rising debt burden".

In other words, Cameron and Osborne have failed in their central goal of cutting the deficit and debt precisely because their austerity policies – combined with a refusal to get a grip on the banks, falling real wages and the boomerang effect of the eurozone crisis – are squeezing the life out of the economy.

"Sluggish growth" is a polite way of putting it. Britain isn't just facing the possibility of a triple-dip recession, after the economy shrank in five out of 10 quarters since the summer of 2010. It's now in a fullblown depression. We're no longer talking about the risk of a Japanese-style "lost decade". The country is in the middle of one, and it stands to be worse than Japan's in the 1990s, according to the Office for Budget Responsibility's own projections.

The economy is stagnating at best, delivering the second-worst performance of the G7 economies in the past two years – after Italy. There has already been a fall in living standards unmatched since the 1920s, with the average worker losing around £4,000 in real terms over the last three years. On current forecasts, real wages will still be at their 1999 level in 2017.

Now the falling value of the pound will intensify that squeeze, with little chance of the benefits for exports in a hollowed-out industrial economy where investment is still 15% below its pre-crash peak. That failure to invest, by corporations sitting on a £777bn cash mountain, has also fed into an alarming drop in productivity.

When you add in the cuts to core public services, tax credits, housing and disability benefits that will hit the poorest hardest, this isn't just an economic disaster. It's a human one measured out in blighted lives for years to come, delivered in the service of a programme that has already failed in its own terms – while shrinking the state and cosseting the corporate sector.

The Tories and their Liberal Democrat allies naturally still blame their predecessors' profligacy. New Labour must of course share the blame – along with the entire City-bedazzled political class – for promoting a deregulated, private debt-fuelled financial system which crashed and burned across the western world. But the claim that its own spending (with a deficit of less than 3% when the crisis hit) caused the crisis itself is an absurdity.

Polls show most people in Britain realise that, and increasingly oppose the government's reckless austerity. But without the unequivocal promotion of a decisive alternative, the risk is that falling living standards and deteriorating privatised services come to be seen as the new normal.

The shape of that alternative is clear enough: a large-scale public investment programme in housing, transport, education and green technology to drive recovery and fill the gap left by the private sector, underpinned by a boost to demand and financed through publicly-owned banks at the lowest interest rates for hundreds of years.

There's no evidence that extra borrowing for growth – as opposed to increased borrowing to pay for contraction, which the bond markets have barely blinked at – would lead to a confidence crisis. And the government already owns controlling stakes in two of Britain's biggest banks that it could use right now to boost lending and finance expansion.

None of that is going to turn round the scale of the coalition's economic failure – which leaves Ed Miliband with a crucial choice. Even if growth picks up in the next couple of years, there's no prospect of a full recovery under the coalition. And after years of falling living standards, Labour's chances of re-election are clearly growing,

So far Miliband has backed a limited stimulus, slower cuts and wider, if still hazy, economic reform. Given the Cameron coalition's legacy and the cuts and tax rises it's planning well into the next parliament, the danger is that Labour locks itself into continuing austerity in a bid for credibility. As the experience of its sister parties in Europe has shown, that would be a calamity for Labour – but also for Britain.